Curious Capitalist

This Is How You Fix Ailing Public Pensions

A tough problem to crack

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In the wake of the Detroit bankruptcy settlement plan announcement a few days ago, I’ve been thinking about whether or not pensioners in that city, who’d see their retirement benefits cut by 34 %, are getting a fair shake. As well as what does the situation in Detroit might imply for other troubled states and municipalities? As I wrote in a TIME cover story when the bankruptcy was announced, I think declaring the city bust was a necessary decision.

My worry was always that, as in parts of Europe or Latin America or even California cities that have gone bankrupt, pensioners would be left holding a disproportionate share of the burden of cuts, while other creditors took less of a haircut. While the initial deal looks more favorable for pensioners relative to some other unsecured creditors, like Wall Street holders of Detroit’s “general obligation” bonds (which could see as little as 20 cents on the dollar), you can bet that the legal wrangling over who gets what in the deal with go on for years. (It’s been 12 since Argentina went bankrupt and the lawyers are still making money there.)

What may be just as important going forward is how to structure public pensions in such a way that we avoid unsustainable return expectations, or massive losses due to risky assets. These are on the rise—between 1984 and 1994 pension funds invested under 5 % of their assets in high return/high risk investments like hedge funds, private equity and venture capital; now, that’s grown to 20 % as funds desperately try to make their pay out numbers. At a conference I attended this week on pension reform sponsored by the Roosevelt Institute, a liberal think tank, participants like Nobel laureate in economics Joseph Stiglitz and University of Massachusetts political science professor Thomas Ferguson had a few ideas to share on that front. Below, the takeaway:

1. Pension funds shouldn’t be in high-risk assets, period. As very few articles on the topic mention, pension money substitutes for social security for many state employees – this is their ONLY money, and there should be legislatively mandated limits on risky assets (lots of pensions below up on CDOs in 2008).

2. They need to be diversified away from state headquartered companies, many of which are major donors to local politicians or to groups that fund them. It’s no accident that some of the most under-funded pensions are also the least geographically diversified.

3. Pensions should be mainly invested only in no or low fee index funds. As a Maryland Public Policy Institute study found, state funds as a whole could have saved $6 billion in 2012 by indexing rather than paying fees to funds that were underperforming the market in any case. As Vanguard fund founder Jack Bogle himself has said, the mutual fund market has become a “ponzy” scheme of sorts, charging high fees for lower than average returns. Making sure pensioners aren’t paying too much for too little should be a huge priority in cleaning up the system.

4. That may require cleaning up campaign financing. As Ferguson pointed out, the number of local politicians receiving funding from Wall Street or anti-pension business interests is increasing. Making sure pensioners get a fair shake will require tackling the money culture—an even tougher task than bringing back Detroit.